Hyperinflation, Currency Competition, and Monetary Reform

Meanwhile, the Verein für Sozialpolitik had put the problem of monetary stabilization on the agenda for its 1923 meeting. Mises had been invited to write one of the expert reports to serve as the basis for the discussions—an unexpected sign of attention.⁸⁰ He later recalled that his “monetary theories have been studied only when and where inflationist policies faced immediate collapse, such as in the German Reich.”⁸¹ The most fashionable book on money in the years before 1923 was written by Albert Hahn, a young economist in Frankfurt. Developing Schumpeter's theory of capital (in which capital was “abstract” purchasing power), Hahn stressed that fiduciary credit expansion had the beneficial effect of creating “forced savings” and thus higher growth rates than could be obtained without inflation. In his book he anticipated virtually all the essential propositions of Keynes's General Theory (1936).⁸² But in 1923, the German economists started having second thoughts about the blessings of inflation. They wished to listen again to the voice of dissent. At the end of February 1923 Mises submitted his manuscript, “Die geldtheoretische Seite des Stabilisierungsproblems” (The Problem of Stabilization Considered from the Point of View of Monetary Theory).⁸³

This title is somewhat misleading. In fact the essay combines a sophisticated analysis of what today would be called the dynamics of currency competition with the first concise statement of Mises's ideas on how to prepare for the transition from an inflationary currency to the gold standard. The essay was one of Mises's most influential works in the sense that it had an immediate and noticeable impact on the economic policy of the German Reich.

Mises began by pointing out that continued inflation would necessarily end up in the collapse of the monetary system:

In recent months, the German Reich has provided a rough picture of what must happen, once the people come to believe that the course of monetary depreciation is not going to be halted. If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency.... That the German mark is still used as money today [January 1923] is due simply to the fact that the belief generally prevails that its progressive depreciation will soon stop, or perhaps even that its value per unit will once more improve. The moment that this opinion is recognized as untenable, the process of ousting paper notes from their position as money will begin. If the process can still be delayed somewhat, it can only denote another sudden shift of opinion as to the state of the mark's future value. The phenomena described as frenzied purchases have given us some advance warning as to how the process will begin. It may be that we shall see it run its full course.⁸⁴

And indeed it did run its full course, at least as far as Germany was concerned. The process accelerated with exponential growth rates during 1923, culminating in the virtual collapse of the currency in October. In the fall of 1923, the Reichsbank operated some 1,700 printing presses twenty-four hours a day, and it used the entire production of thirty paper factories. Eventually the paper supply threatened to become a bottleneck.⁸⁵

For some time, Mises had to fear that his essay would not be published in time to influence policy. In May, he wrote to the publisher, expressing his misgivings about the delay.⁸⁶ In his essay, Mises discussed two scenarios of the displacement of the inflationary currency. Either this process can occur in a panic such that the bad money is abandoned in a few days or even in a few hours. Or the currency substitution takes place relatively slowly, thus assuring a smoother transition. Mises had firsthand experience of the slower process. The description given in his essay fits observations he made during the high postwar inflation in Vienna:

[The] practice of making and settling domestic transactions in foreign money or in gold, which has already reached substantial proportions in many branches of business, is being increasingly adopted. As a result, to the extent that individuals shift more and more of their cash holdings from German marks to foreign money, still more foreign exchange enters the country. As a result of the growing demand for foreign money, various kinds of foreign exchange, equivalent to a part of the value of the goods shipped abroad, are imported instead of commodities. Gradually, there is accumulated within the country a supply of foreign monies. This substantially softens the effects of the final breakdown of the domestic paper standard. Then, if foreign exchange is demanded even in small transactions, if, as a result, even wages must be paid in foreign exchange, at first in part and then in full, if finally even the government recognizes that it must do the same when levying taxes and paying its officials, the sums of foreign money needed for these purposes are, for the most part, already available within the country. The situation, which emerges from the collapse of the government's currency, does not necessitate barter, the cumbersome direct exchange of commodities against commodities. Foreign money from various sources then performs the service of money, even if somewhat unsatisfactorily⁸⁷

Mises contrasted this smooth transition with the panic scenario, which, as he said, was more likely in the context of the 1923 German inflation:

Things will necessarily be much worse if the breakdown of the paper money does not take place step-by-step, but comes, as now seems likely, all of a sudden in panic. The supplies within the country of gold and silver money and of foreign notes are insignificant. The practice, pursued so eagerly during the war, of concentrating domestic stocks of gold in the central banks and the restrictions, for many years placed on trade in foreign moneys, have operated so that the total supplies of hoarded good money have long been insufficient to permit a smooth development of monetary circulation during the early days and weeks after the collapse of the paper note standard. Some time must elapse before the amount of foreign money needed in domestic trade is obtained by the sale of stocks and commodities, by raising credit, and by withdrawing balances from abroad. In the meantime, people will have to make out with various kinds of emergency money tokens.⁸⁸

In the early fall of 1923, several institutions sprang up spontaneously that would lead Germany on the path to replacing the mark. In October, the Hamburger Bank started issuing notes covered by foreign exchange and a similar bank was set up in Kiel. Meanwhile preparations were made in the Rhineland to establish a bank on a gold standard. The disintegration of the German economy into several currency areas was imminent.⁸⁹ But history took a different course.

In early August, Karl Helfferich had presented the government with a rescue plan. Helfferich's idea was to create new confidence among the population that the decline of the mark had reached its limit. His strategy was based entirely on speculations about the layman's monetary psychology.⁹⁰ Helfferich proposed to establish a new bank to be called the Rentenbank endowed with a claim to 3,200 million marks backed up by all commercial assets in Germany. Thus all German firms including farmers and banks were said to have a collective liability to the Rentenbank. The Rentenbank would then issue Rentenmarks.

In the mind of the average German citizen, the Rentenmark—“founded on value-stable soil”—had successfully stopped the further erosion of the mark. But the end of the crisis had a very different source: on the same day the first Rentenmarks came into circulation, the printing of new marks was halted. As Mises had emphasized in his report to the Verein für Sozialpolitik, the “first precondition of any monetary reform is to halt the printing press.”⁹¹

Mises believed it was also necessary to bring about a return to gold, advocating a “100% marginal gold standard.”⁹² These two measures were intimately connected. Together they were designed to drive the government out of the monetary arena. He explained:

The reason for using commodity money is precisely to prevent political influence from affecting the value of the monetary unit. Gold is not the standard money [merely] on account of its brilliance or other physical and chemical characteristics, but because the increase or decrease of its quantity is independent of any orders issued by political powers. The crucial function of the gold standard is that it makes changes in the quantity of money subject to the laws determining the profitability of gold production.⁹³

Yet which particular type of gold standard did Mises have in mind? Apparently, he believed that a full-blown gold standard, which involved the circulation of gold coins, was not necessary or advisable under present circumstances. He also believed that a gold exchange standard, in which the currency consists exclusively of fractional-reserve banknotes, was acceptable if bank laws strictly limited the issuance of these banknotes.

His prewar studies had already alerted him to the likelihood that fractional-reserve banknotes would be issued on a growing scale and that there was no natural limit to this type of inflation if it proceeded slowly in a step-by-step manner. His 1923 proposal therefore advocated 100 percent reserves for all additional note issues. Mises's plan thus took the present existence of fractional-reserve notes as irreversible and focused instead on the prevention of any further issuance of such notes. All additional issues must be completely covered by gold deposited with the issuing bank.

The foundation and cornerstone of the provisional new monetary system will be the absolute prohibition of the issue of any notes not completely covered by gold. The amount of Reichsbank banknotes, of banknotes of the Darlehenskassen, of emergency currency of any kind, and of token money will be legislated to be—after deduction of the stocks of gold and of foreign exchange held by the Reichsbank and by the private banks of issue—the maximum amount of German notes in circulation. Any extension of this maximum must be avoided under any circumstances, except for the facilitation of end-of-quarter payments that we have already mentioned. Any note issue beyond this limit must be fully covered by a deposit of gold or of foreign exchange with the Reichsbank. This is obviously the adoption of the main provision of Peel's Bank Act with all its deficiencies. But for the moment these deficiencies hardly have any practical significance. Our present goal is merely to abolish inflation by stopping the printing press. This objective, which alone we presently strive for, is best served through a prohibition of note issues without metallic backing.⁹⁴

To determine the most suitable redemption ratio between gold and the currency, Mises recommended that the monetary authority should proceed by (1) stopping the printing press and then (2) letting the exchange rate between its currency and gold stabilize on the market. In short, stop inflating and then let the market determine the gold value of the mark. Mises maintained the same views on the technical aspects of monetary reform for the rest of his career. In 1953, he made the case for a 100 percent marginal gold standard in a more detailed and thorough manner, when he added a fourth section to the English edition of The Theory of Money and Credit.⁹⁵

Mises rejected the idea, which would later be maintained by the influential Gustav Cassel, that there might not be enough gold available to put all countries of the world on a gold standard. Mises argued that the pricing process would always equilibrate demand and supply. Moreover, he observed that the global gold supply had increased since 1914 and that trade had decreased, so that there was no great danger of lower-than-1914 prices. Finally, it was not necessary to bring about a full-blown gold circulation.

[A] return to the gold standard would not necessarily mean a return to the actual use of gold money for small- and medium-sized payments within the country. For even the gold exchange standard developed by Ricardo in his work, Proposals for an Economical and Secure Currency (1816), is a true and sound gold standard. The monetary history of the recent decades has clearly shown this.⁹⁶

Following Ricardo further, he even suggested legislating that the Reichsbank only be obliged to redeem gold ingots, rather than gold coins. This would act as an effective deterrent against redemption demands that the Bank might not be able to comply with in its first years of operation under the gold standard. At some later point, it might however be useful to counteract the note-using habits of the population, and thus to replace the note circulation by an effective gold circulation, in order to prevent future over-issuance of banknotes.⁹⁷

It turned out that Mises's apprehensions about the remaining inflation dangers in a gold exchange standard were justified. Writing many years later in Human Action, he regretted the moderate stance he had taken in his earlier writings because it left too much power in the hands of the government, which through its monetary authority still issued the gold exchange currency. He denounced the root error behind the gold exchange standard, which was in seeing “the costs involved in the preservation of a metallic currency as a waste.” This had been the mistake of both Adam Smith and David Ricardo and thus enjoyed immense credibility and prestige. Yet Mises had come to consider it as “one of the most serious shortcomings of the classical economists.”

In dealing with the problems of the gold exchange standard all economists—including the author of this book—failed to realize that it places in the hands of governments the power to manipulate their nations' currency easily. Economists blithely assumed that no government of a civilized nation would use the gold exchange standard intentionally as an instrument of inflationary policy.⁹⁸

Mises's case for the restoration of the gold standard was obviously based on the premise that an inflation-free monetary order would be a good thing. But what if someone objected to this view on fiscal grounds? These “conditional inflationists,” as Mises called them, admitted that inflation was not necessary to equilibrate the balance of payments. But they held that in some situations it was suitable and expedient for the government to use inflation as a particular form of taxation. Mises observed that paper-money production was indeed one of three possible resources of government revenue, the other two being taxation and borrowing.⁹⁹ In his view, economic science could not determine which of these techniques should be used. But it had a few things to say about the social and economic consequences of paper-money inflation, and also about its political significance. Mises suggested that inflation was by its very nature undemocratic:

a government always feels compelled to resort to inflationary measures when it is unable to issue bonds and when it does not dare to increase taxes, because it fears to lose support for its system of government if the latter's financial and general economic consequences become obvious too quickly. Thus inflation becomes one of the most important psychological instruments of an economic policy bent on camouflaging its effects. In this sense it may be called a tool of anti-democratic policy because it makes it possible, through the deception of public opinion, to perpetuate a system of government, which would have no prospect of public approval if all things were openly explained.¹⁰⁰

Mises here rediscovers a fact that had been first stressed in the writings of Nicolas Oresme, a fourteenth century scholastic and author of the very first monetary treatise. Oresme pointed out that debasement (the inflation technique of his age) served to enrich the princes at the expense of the community. The princes thereby turned from kings into tyrants:

I am of the opinion that the main and final cause why the prince pretends to the power of altering the coinage is the profit or gain which he can get from it... the amount of the prince's profit is necessarily that of the community's loss. But whatever loss the prince inflicts on the community is injustice and the act of a tyrant and not of a king, as Aristotle says.... And so the prince would be at length able to draw to himself almost all the money or riches of his subjects and reduce them to slavery. And this would be tyrannical, indeed true and absolute tyranny as it is represented by philosophers and in ancient history.¹⁰¹

Recalling the intimate relationship between the welfare state and the warfare state, a relationship emphasized by the nineteenth century free-trade movement of Cobden, Bright, and Bastiat—Mises stressed that the inflationist mindset, which also underlies proposals in favor of seemingly moderate conditional inflation, is not an isolated phenomenon, but part and parcel of the reigning ideology:

[Inflationism] belongs to imperialism, to militarism, to protectionism, to statism, to socialism—in the same way as the sound-money policy of the champions of the gold standard had belonged to liberalism, to free trade, and to pacifism. And just as the global catastrophe that has swept over mankind since 1914 is not an elementary fact of nature, but the necessary consequence of the ideas that rule our times, so is the destruction of our monetary system nothing but the necessary consequence of the dominance of certain ideologies of monetary policy.¹⁰²

A few months after the stabilization of the mark, the position of the banks and other private firms that depended on continued inflation in Germany had become untenable and they started scrambling for cash.¹⁰³ Many went under, the most prominent case being the Biedermann Bank, whose president was Joseph Schumpeter.

In the interwar period, the large Austrian banks had consciously sought to win economists of Schumpeter's standing as front men to reassure their creditors from abroad. They had also asked Mises for support several times, but he always rejected these proposals because he thought the commercial banks were all bankrupt.¹⁰⁴ This was not a pose. He had in fact always kept his personal account with Austria's postal savings bank.